President George
W. Bush's tax agenda is largely focused on making the 2001 and 2003
tax cuts permanent. This is sound policy. The bulk of those tax
cuts are pro-growth initiatives that have lowered marginal tax
rates on work, saving, and investment. These include:

Lower
marginal income tax rates: The top tax rate has been reduced
from 39.6 percent to 35 percent, and other income tax rates have
been reduced by similar amounts. While not dramatic, these rate
reductions have increased incentives for productive activity.

Reduced
double-taxation of dividends and capital gains: The top tax
rate on dividends used to be 39.6 percent, and the top tax rate on
capital gains used to be 20 percent. Both rates are now 15 percent,
significantly reducing the double-taxation imposed on business
investment, particularly for dividends.

Death tax
repeal: Though not effective until 2010, and then only for one
year, the phase-out of the death tax is a much-needed reform to
eliminate a particularly pernicious form of double-taxation. It is
difficult to estimate the extent to which this reform has
encouraged families to allocate their resources more productively
because there is uncertainty about whether the tax will be
permanently repealed.

These are the
"crown jewels" of the President's tax agenda, but all of these tax
cuts will disappear at the end of either 2008 (dividends and
capital gains) or 2010 (income tax rates and death tax) unless they
are made permanent. In other words, the economy would be hit by a
major tax increase. This raises three concerns:

Higher taxes
encourage additional spending. There is no fixed relationship
between taxes and spending. But history suggests that politicians
generally will spend every penny the government collects-and then
as much more as they think they can borrow without making voters
nervous about deficits and the debt. Tax increases, then, almost
surely have the effect of loosening the reins on government
spending. In some cases, such as the 1990 tax increase, federal
spending rose significantly. In other cases, such as the 1993 tax
increase, spending grew by a smaller amount. But the long-term
relationship of more taxes leading to more spending is
unavoidable.

Higher tax
rates hurt competitiveness and growth. All tax increases cause
economic harm because they encourage bigger government. But some
types of tax increases do more economic damage than others.
Specifically, higher marginal tax rates on work, saving, and
investment reduce incentives to engage in productive behavior. If
the Bush tax cuts are allowed to expire, this is precisely what
will happen. The increased tax on dividends, for instance, would
hit the economy hard. The maximum rate of double-taxation would
jump by more than 100 percent, climbing from 15 percent to 35
percent (and potentially 39.6 percent in 2011 if income tax rates
are allowed to increase). This will hurt investment and financial
markets. The capital gains tax rate would not jump as dramatically,
though even small increases in the rate have a significant impact
because investors always can avoid the additional layer of tax by
not selling assets. This would hinder the allocation of capital to
more productive uses. And the re-imposition of the death tax, in
theory, would have the worst economic impact because it would
impose a marginal tax rate of 60 percent on any additional wealth
that certain taxpayers accumulate. This would dramatically reduce
incentives for these taxpayers to engage in productive behavior and
dramatically increases incentives to engage in costly and
inefficient tax-planning strategies. The only silver lining-albeit
a very perverse one-is that many of the targeted taxpayers have
doubted all along that the tax would actually be repealed. This
means that a significant economic hiccup as 2011 approaches is less
likely-though it also means that the economy has missed out on the
faster growth that would have occurred had those taxpayers believed
that the death tax was going to die.

The tax
rates/tax revenue downward spiral. If the Bush tax cuts are not
extended and the economy is hit by a sizeable increase in marginal
tax rates, economic performance will falter. This translates into
fewer jobs, lower incomes, and diminished profits, and that means
less money for the government to tax. In some cases, such as with
the capital gains tax, the reduction in the "tax base" can be so
great that the government collects less revenue at a higher tax
rate. In most cases, though, the shrinkage in the tax base merely
means that the revenue increase will be smaller-perhaps
dramatically smaller-than estimated. Sadly, government
revenue-estimating models are very simplistic and fail to measure
any impact of tax policy changes on economic performance. As a
result, politicians will fall into a rut of raising tax rates,
boosting spending, and then raising tax rates again when revenues
are lower than anticipated. This type of downward spiral already
has caused great damage in Europe. It would be a terrible mistake
to let America travel down the same path to economic stagnation and
high unemployment.

The President is
right to demand that Congress make these tax rate reductions
permanent. These tax cuts have helped the U.S. economy easily
outperform the world's other major economies.

Deficits Are a Symptom, Spending Is
the Disease

There is a
mistaken belief in Washington that fiscal policy should focus on
lowering the budget deficit rather than reducing the burden of
government. This confuses cause and effect. Government spending
diverts resources from the productive sector of the economy. That
diversion imposes a cost because the higher spending misallocates
some portion of the economy's labor and capital.

That cost might be
worthwhile if policymakers were funding only the legitimate and
proper functions of a central government-such as national defense,
a court system, and other genuine "public goods." These types of
outlays facilitate the environment in which private-sector wealth
creation can take place. But most government outlays fail to meet
the "public goods" test. The bulk of government spending today is
for transfers and consumption.

This is why it is
a mistake to obsess about the deficit. Even if the federal budget
magically had a $500 billion surplus, the argument for eliminating
large amounts of government spending would remain the same.

The deficit only
measures the degree to which programs are financed by borrowing
rather than taxes. Even if one makes the heroic-and completely
implausible-assumption that higher taxes do not lead to higher
spending, such a policy merely represents a jump from one frying
pan to another.

Some assert that
deficits are an especially bad way to finance government because
they boost interest rates. This is a dubious claim. Interest rates
are very low in Japan, for instance, even though Japan's debt and
deficits are more than 100 percent higher than America's. The U.S.
experience also is illustrative: interest rates fell dramatically
between 2000 and 2004 as the fiscal balance shifted from a $236
billion surplus to a $412 billion deficit.

This does not mean
that higher budget deficits cause lower interest rates. Instead, it
simply means that in a world where $2 trillion changes hands every
day, "big" increases in the budget deficit are tiny compared to the
money flowing through global capital markets. Other factors, such
as monetary policy and demand for capital, are far more likely to
cause interest rates to shift.

None of this
should be interpreted to mean that deficits are irrelevant. As a
matter of political economy, deficits enable politicians to
disguise the price of government from taxpayers. This facilitates
increases in the size and burden of federal spending. It also is
worth noting that future deficits-assuming politicians fail to
control entitlement spending-will be far larger than deficits
today, perhaps exceeding 15 percent of GDP. This is uncharted
territory, and the economic consequences are difficult to
predict.

But it is
important to realize that there also would be dramatic adverse
consequences if exploding entitlement expenditures were financed by
higher taxes. That is not uncharted territory. Europe's slow-growth
welfare states are poignant examples of the economic damage caused
by governments that consume half of economic output. It also is
worth noting that European nations, on average, have budget
deficits similar to U.S. levels, and European government debt
actually is higher-confirming that higher taxes finance levels of
government spending in the long run.

The Failure to Address Tax
Reform

The bad news is
that the President's budget is silent on the issue of fundamental
tax reform. This does not preclude Administration action at some
future point, but it certainly suggests that the White House is not
planning on a major effort to fix the internal revenue code. This
is a missed opportunity. In a competitive global economy, America
no longer can afford a tax system that combines the worst features
of special-interest deal-making and class-warfare
redistribution.

The absence of tax
reform is particularly puzzling given the growing evidence that the
flat tax is a very effective way to boost growth and reduce tax
evasion. Nine former Soviet-Bloc nations have adopted variations of
the flat tax, and the new systems have been a big success. This
should not be a surprise. After all, Hong Kong has been the fastest
growing economy in the world since it implemented a low-rate flat
tax in 1947.

Some of the
developments in Eastern Europe are worth noting:

Estonia was the
first to adopt a flat tax, back in 1994, and it is now known as the
"Baltic Tiger" because of its fast growth. The government is even
in the process of lowering the flat tax rate from 26 percent to 20
percent to reap even bigger benefits.

Russia's
13-percent flat tax has been in effect just since 2001, but already
personal income tax revenues have skyrocketed by 106 percent-and
that is after adjusting for inflation!

Slovakia's
19-percent flat tax is even younger, taking effect in 2004, and yet
the results have been stupendous. On a per-capita basis, there is
now more foreign investment in Slovakia than anyplace else in the
world.

There also is good
news in nations like Latvia, Lithuania, Romania, Georgia, Ukraine,
and Serbia. The flat tax should not be seen as an elixir, of
course, particularly if nations are still struggling with
rule-of-law, property rights, and sound money problems. But it is
an ideal tax system for nations seeking faster growth and better
tax compliance. That last point is particularly worth highlighting
because one of the distasteful features of the Bush tax agenda is
an ephemeral "reduce the tax gap" proposal. This presumably means
giving the IRS more power to harass entrepreneurs and other
taxpayers. This is akin to a dog chasing its tail. Low tax rates
and a fair tax system is the recipe for tax compliance.

Supply-Side Tax Cuts
Work Best

Tax policy from
2001 to the present offers an important economic lesson. Tax cuts
do not help the economy by giving people more money to spend. Any
money "injected" into the economy with tax cuts is offset by the
money "withdrawn" from the economy as the government either reduces
a surplus or increases a deficit. Instead, certain types of tax
cuts can help the economy by changing the "price" of productive
activity. For example, lower income tax rates mean that the
relative price of working has declined. Lower tax rates on
dividends and capital gains mean that the relative price of
investing has declined.

But other types of
tax cuts have little or no impact on economic decision-making.
Child credits and tax rebates, for instance, do not have any
measurable impact on growth because they do not alter incentives to
work, save, and invest. Indeed, this is why the 2003 tax
legislation worked so much better than the 2001 tax legislation.
The first bill was dominated by the child credits and the rebate,
whereas the 2003 legislation lowered marginal tax rates on
dividends and capital gains while also accelerating the lower
income tax rates promised in the 2001 law. This is why the
economy's performance has been much stronger since the 2003 law.
The 2001 law's impact was much more modest.

Moreover, this
explains why pro-growth tax cuts have a much smaller impact on tax
revenues than rebates, credits, deductions, and other preferences.
When tax rates are lowered and people have more reason to engage in
productive activity, this results in more taxable income. Depending
on the increase in taxable income and the change in the tax rate,
the actual reduction in tax revenue will be lower than forecast by
"static scoring."

The primary goal
of tax policy should be faster growth. This is why permanent tax
cuts are important, especially the tax rate reductions that
increase incentives to work, save, and invest. The President
presumably wants all his tax cuts made permanent, but some tax cuts
generate more bang for the buck than others. Capital gains and
dividends should be the first priority, quickly followed by the
lower income tax rates and death tax repeal.

Daniel
J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the
Thomas A. Roe Institute for Economic Policy Studies at The Heritage
Foundation.